Friday, September 29, 2006

The Most Underrated Trading Virtue

Those anti-motivational folks at Despair have it right: there's nothing like the winds of change to blow away the unsuspecting trader.

A worthwhile book that I've begun reading is Master Traders by Fari Hamzei of Hamzei Analytics. There's a very nice segment from Jeff deGraff:

Contrary to what 99 percent of the investment population thinks, trading is not about being right. Being right is easy. Trading is about being wrong; and navigating this inevitable occurrence distinguishes the winners from the losers in the long run...The road to riches is littered with the bodies of those who believed that being right required conviction and stamina...but the line between conviction and stubbornness is at best vague (p. 13-14).

Although trading coaches wax poetic about trading plans and maintaining discipline with these plans, rigidity in the face of a plan going sour is no virtue. The winds of market change can shift quite dramatically when large participants enter with directional positions. It is for this reason that mental flexibility is perhaps the most underrated trading virtue.

Yesterday's market update provided a perfect example of the value of mental flexibility. During the opening ten minutes of trade, I observed strength in the Russell futures and a positive tone to the NYSE TICK. My historical studies told me that, under these conditions, the odds of taking out the previous day's highs were well north of 75%. That was my initial plan.

Then came the winds of change.

By 8:48 AM, I was noticing selling in the Russell futures and especially program-driven selling. The presence of institutional sellers as we neared the previous day's high led me to consider an alternate market scenario: perhaps we were in the process of forming a range for the day. By 9:01 AM, I was looking for the previous day's average price of 1347 in the ES to be a midpoint of this developing range, noting an attempt to form a short-term base below that level. (The eventual midpoint was 1346.75).

At 9:14 AM, the market had indeed rallied from this base, but the quality of the rally was substandard: certainly nothing like the opening buying. By 9:34 AM, the winds of change had come full circle. From expecting to take out the previous day's highs, I now work with the hypothesis that we had put in the high for the current day. Instead of buying strength, I was fading rallies--a strategy that worked well for the short-term trader.

Within an hour's time, I had completely revised my view of the market. Had I formed a plan at the start of trading and stuck with it in the name of discipline, the winds of change would have hurled some projectiles at my P/L.

When you're a short-term trader, think of the market as your dance partner. It leads, you follow. Your job is to sense your partner's intentions and move fluidly with each shift of direction. Your trading plans and predictions mean nothing to the market; only ego makes the trader want to lead his or her dance partner.

Be a good follower, and you'll be a market leader.